Tuesday, November 30, 2010

"The Euro is to blame for the current crisis in Europe". I am sure this sentence sounds familiar to many. The argument is simple: as Euro members cannot devalue their currencies anymore, they do not have an option to improve their economic conditions (by favoring exports), growth suffers and their high levels of debt become unmanageable. The Euro area is not an optimum currency area (it lacks labor mobility, fiscal transfers, etc.) so this was a crisis waiting to happen. Paul Krugman says it here, Simon Johnson says it here and you can find many more articles in the business press repeating these arguments.

Let me (partially) disagree with that statement and just bring an alternative view to this issue. It is not a view that denies the importance of exchange rates or the fact that the constraints of the Euro area (one monetary policy might not fit all) might be hurting Euro economies but I think that it is healthy to question our priors on the importance of the exchange rate in explaining some of the empirical phenomena we observe these days in Europe.

A couple of disclaimers before I present my arguments: these are difficult questions to answer. When looking at historical episodes, one needs to control for all variables and their behavior during that time. I will not do that here. Partly because those arguing about the costs of the Euro do not do it either, partly because it will involve heavy statistical analysis which might not be suitable for a blog.

A second disclaimer: I will use Spain as an example because it tends to be used as an example of the problems faced by Euro members and because it is seen as the next in line to ask for funding (it is not related to my nationality...).

Spanish unemployment has reached 20% during the current crisis and there is a sense that unemployment will remain very high for the foreseeable future. The logic says that if Spain could devalue, unemployment would fall very fast. How fast? Let's go back in time to when Spain could and did devalue. The previous recession in Spain (if we do not count the slowdown in 2002 as a recession) was in 1992/1993. At that point Spain had a fixed exchange rate relative to other European currencies. Prior to the crisis it had gone through a period of real exchange rate appreciation (because of high inflation) that had eroded its competitiveness. Very similar to what we saw before the current crisis. The difference is that in 1993 Spain decided to devalue its currency (three times between June 1992 and September 1993). What happened to unemployment during the years that followed?

Below is the picture of the unemployment rate before and after the devaluation. We cannot compare with the current crisis yet, we will need to wait a few years before we see how fast or slow unemployment comes back to a "normal" level, but as we can see in the chart below, unemployment remained extremely high in the years that followed the devaluation of the peseta. Growth picked up but not fast enough to generate employment at a fast enough rate.

Second observation: if staying outside of the Euro area produces significant benefits, a quick comparison between the UK and Spain should be very revealing. The UK has seen a large devaluation of the Pound during the crisis while Spain had no option to devalue its currency.

Below are two charts that summarize the fiscal tensions that each of these two countries are witnessing in terms of fiscal policy as well as the overall economic growth before and after the crisis. There are many ways to read these charts and I am aware that I am abstracting from many other variables but keep in mind that they could make the argument stronger or weaker depending on how you read those other variables. For example, one could argue that the real estate bubble in Spain was more significant than the one in the UK (which is true if one looks at activity in the construction sector as a measure of the bubble) so it is likely that the crisis had a much larger effect on Spain than the UK. One could argue, on the contrary, that the crisis of the financial sector had a larger impact on the UK than in Spain so it should be the UK economy that had a sharper downturn. I ignore all these arguments and simply compare a couple of variables during these years (by the way, data coming from the World Economic Outlook Database, IMF).

My reading of these two charts is that differences so far are small. The best argument one could use to highlight the costs of the Euro for Spain would be the forecasted growth for 2010, below that of the UK (but this ignores a better performance during the previous two years as well as possibly the positive effects of the Euro in the years that preceded the crisis). Apart from this, the rest looks very similar. In fact it looks as similar as if I were to compare a pair of two random European countries (within or outside of the Euro area).

A more direct comparison of the effects of the Euro could potentially be seen below in a chart of the relative performance of Spanish and UK exports since 1995. Despite the deterioration of competitiveness of Spain because of the Euro (and higher inflation), exports grew at a faster rate than in the UK (data is from WDI, World Bank, exports measured in current USD, last available year 2008).

So if the Euro is not to blame what do we make out of all the efforts of countries like Germany or France to try to save the offenders (Greece, Ireland, Portugal and Spain) from default? Isn't this linked to the Euro project and a potential failure of this project? Maybe, but there is something which is at least as important: in an integrated area (the European Union not to be confused with the Euro area), there are so many economic linkages, both in trade and capital flows, so that the performance of each individual economy is strongly linked to the performance of others. This is not because they share a currency but because they are highly integrated. Sweden has announced that they will provide funding to Ireland - this is not because they share a currency (they do not), but because there are strong links (e.g. financial links) that makes it in its best interest to do so. The Mexican bailout after the 1994/95 crisis had nothing to do with the sharing of a currency but with the economic interests of the US (and the IMF) in not seeing Mexico go into an even deeper crisis. And in that case, as it would happen with Spain or Ireland today, the existence of a currency in Mexico made matters worse as the devaluation sent all the USD liabilities of the Mexican economy to an unsustainable level.

Sharing a currency has its costs and benefits. The costs are mostly about losing the ability to manage monetary policy as a stabilizing tool. These costs tend to be more visible during times of crisis when we are asking monetary policy to act strongly. So no surprise that this is a good time to ask ourselves whether the Euro is working and whether it was a good idea in the first place. But to reach a conclusion we need to look a broader set of issues that go beyond sharing a currency and a central bank. If we simply stick to the textbook conclusion of why fixed exchange rates are bad, we might miss the bigger picture.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).